Buoyant Bonds

From Greece to Ireland to Portugal, every few months seems to bring a new debt crisis. Italy, Spain and France also have debt woes, and Japan's national debt is more than 200% of its GDP. Not that Americans have any reasons to feel smug about foreign fiscal flaws.

The world seems to be awash in debt, especially government debt. Considering that government issues are crucial to the world's bond markets, fixed-income investments have held up surprisingly well. The future is unknown, but some planners say they expect to deliver respectable returns by embracing prudence and rejecting panic.

DEBTS UP, BONDS SOAR

Ordinarily, if any product or service has such a huge increase in supply, the price will drop. That hasn't been the case with Treasury issues; in fact, prices have gone up as the supply has increased.

"Ten years ago, in August 2001, the total U.S. Treasury debt was about $5.7 trillion," says John Donaldson, director of fixed income at Haverford Investments in Radnor, Pa. "By the end of 2007, before the financial crisis of 2008, that debt had grown to $9.2 trillion." And now, after all the federal efforts to energize the flagging economy? "Treasury debt is $14.6 trillion, and still growing," Donaldson says. "Those are extraordinary numbers." By that measure, the debt of the federal government has increased by more than 150% in the past decade.

Nonetheless, "Back in 2001, the 10-year Treasury was yielding over 5%," Donaldson notes. "At the end of 2007, that yield was over 4%," Lately, it's settled some days at less than 2%.

Falling bond yields, of course, mean rising prices and profits to buy-and-hold investors. In August, for example, Vanguard's Long-Term Treasury Fund was showing an annualized 10-year return of 6.7% per year. By comparison, the S&P 500 had an annualized return of 2.2%.

Such an anomaly might be explained by the fact that U.S. Treasury issues are unique. "They're still the financial asset of choice for safety," Donaldson says. As crisis after crisis has arisen since the beginning of this century, investors worldwide have parked their money in Treasuries, driving up prices and depressing yields.

Beyond Treasuries, though, the entire fixed-income market has held up well, even as government debt ballooned. Pimco's huge Total Return bond fund also had a 10-year annualized return of 6.7%, while Vanguard's Total Bond Market Index fund returned 5.6% per year.

Through the first half of 2011, Morningstar reported that all taxable bond funds were up 5.5% a year for the prior 10 years, versus the 4.2% annualized return of domestic equity funds, while municipal bond funds returned a respectable (and tax-advantaged) 3.9% a year. In short, fixed-income investors have enjoyed returns equal to or greater than those of equity investors, with much less volatility, despite the surge in sovereign debt.

Why have fixed-income investments performed so well in a time of high government spending? There may be some reasonable explanations. Cash equivalents yield little or nothing, and that's unlikely to change for a while.

"The Fed has stated that it will keep short-term interest rates low at least through mid-2013," says Brian Schneider, senior portfolio manager of Invesco Fixed Income. Investors looking for yields that go beyond decimal points have to go elsewhere, and the bond market is a logical place to start.

At the same time, stocks continue to worry many investors, after the crashes of 2000-2002 and 2008-2009. An 18% drop in the S&P 500 from April to August this year, complete with wild daily price swings, reinforced concerns about volatility.

Also, not all of the supply-and-demand figures are discouraging for bond investors. "In recent years, U.S. consumers and corporations have deleveraged quite a bit," Donaldson says. "The same is generally true for large multinational companies around the world." That means even though the U.S. and other major nations have stepped up borrowing, cutbacks in other areas have helped suppress overall debt levels.

MORE MONEY

Historically low cash yields and volatile stock markets may continue for some time, so where's the risk in bonds? Perhaps from accelerating inflation. "The Fed might not have more tricks in its bag, while substantial spending cuts and tax increases may be politically unattainable," Schneider says.

In such a scenario, the U.S. and other governments could paper over their debt problems with more money, resulting in higher inflation. An increase in inflation, in turn, could send interest rates higher and sting bonds. According to Morningstar's Ibbotson Associates, when inflation peaked from 1973 through 1981, running at 9.2% a year, both long-term government and corporate bonds returned a puny 2.5% a year, far behind increases in the cost of living.

Such an outcome is far from certain, though, asserts Robert Tipp, chief investment strategist for Prudential Fixed Income in Newark, N.J., who believes the wait for much higher interest rates might prove futile. "During the 90-year period prior to the 1960s, long-term interest rates tended to remain below 4%," he says. "One reason is that government bonds were perceived as one of the safest investments, so investors accepted very low inflation-adjusted yields." Similarly, United Kingdom long-term government bond yields spent most of the 20th century below 4%.

"Even in the most recent decade, consumer price inflation decelerated despite strong commodity price increases," Tipp says. Ibbotson data show inflation declined from 8.1% in 1971-1980 to 4.5% in 1981-1990; 2.7% in 1991-2000; and 2.3% in 2001-2010. The Fed may have increased its ability to control the level of inflation in recent decades, Tipp says.

Taming inflation might not guarantee a peaceful bond market, however. "We see risks of deflation or inflation, and we can't tell which way things will go," says Mike Martin, president of Financial Advantage, a fee-only advisory firm in Columbia, Md. "In this environment, we prefer to own equities. Corporations can adapt. Bonds, on the other hand, can do only two things: pay or default."

That said, Martin is unlikely to load up on equities. "We think valuations are high, and they will come down as earnings fall," he says. "In addition, our client base consists mainly of retirees and people who will retire within five years. They have to invest for income, and they can't just leave money in the bank because yields are so low. Therefore, we have about 35% of clients' portfolios in fixed income."

TRASHING TREASURIES

With the certainty of low yields and the uncertainty of inflation or deflation, choosing fixed-income investments can be challenging. Among several fixed-income experts, few themes - and several differences of opinion - emerge.

Many investment professionals agree that Treasuries excite little interest. "I do not own U.S. Treasuries at these levels," says Gary Gordon, president of Pacific Park Financial, an RIA firm in Aliso Viejo, Calif.

"Are you getting paid enough to take the risks of Treasuries?" asks Kevin Kearns, co-portfolio manager of the Loomis Sayles Absolute Strategies Fund. Mark Wilson, vice president of the Tarbox Group, a wealth management firm in Newport Beach, Calif., adds that his firm has no government bonds.

Nevertheless, some planners and fixed-income managers find reasons to hold some Treasuries. "The United States benefits from having the world's reserve currency while our Treasury bonds make up the largest, most liquid market in the world," Schneider says. "I think Treasury rates will remain in a trading range. It's hard to find the short end of the Treasury yield curve appealing, at today's rates, but seven- to 10-year Treasuries look better."

COUNTING ON CORPORATES

In contrast to Treasuries, corporate bonds have backers. Martin prefers funds holding corporate bonds to sovereign issues because "balance sheets are stronger and they pay more."

Schneider, though, finds that corporate markets are less liquid than they have been. "We like agency mortgage-backed securities," he says. "Mortgages were under pressure when the risk of U.S. default was in the news. Now that default seems to be off the table, these securities make more sense."

Wilson, whose firm holds positions in high-quality, low-duration corporate bonds, also invests in munis, mainly California issues that offer state and federal tax exemption. "S&P keeps downgrading California issues, including some we own, but that hasn't affected the pricing," he says. "We mainly focus on individual securities, where we have more control than in funds. Bond ladders might go out to seven years, where we find good values these days." Martin, conversely, generally avoids the muni market because of concerns about the fiscal strength of state and local governments.

For financially strong issuers, some planners are venturing offshore. "I have increased my positions in WisdomTree Asia Local Debt ETF, which is unhedged, and in the dollar-hedged PowerShares Emerging Markets Sovereign Debt ETF," Gordon says.

Has Gordon added to those holdings out of concern over rising debt in developed nations? "An unsustainable debt path is only part of the reason," he says. "Asia and emerging markets are getting closer to the end of their respective tightening cycles. Those bond yields will come down as prices go up." In contrast, rates in the developed world are likely to rise, whether due to inflation or lack of faith in the issuer's ability to pay.

"Asian bonds are safer than those from Europe or the United States - no deficits, no austerity and plenty of growth," Gordon explains. Kearns says that Mexican government bonds, yielding 4.5%, may have a better risk-reward profile than U.S. Treasuries yielding about 2%.

Enthusiasm for offshore bonds disappears when talk turns to Europe. In a post for SeekingAlpha.com, Gordon wrote: "Toxic assets aren't subprime mortgage bonds ... they are the sovereign debts of the Euro zone."

In terms of the debt crisis, Kearns refers to Europe as Ground Zero. "Beyond countries such as Spain and Italy, there are signs of problems in France. Contagion could spread to Germany and the smaller countries of Europe."

CHOOSING A DIRECTION

With such a cloudy outlook, working with a seasoned hand might be the preferred route. "Find out if your manager or fund has a buy-and-hold approach or if it's possible to go both long and short," Kearns says. "Are investments possible in many fixed-income asset classes around the world? Many people would prefer a flexible management philosophy."

Martin's firm relies on a mix of taxable bond funds. "The average duration of our funds works out to about three years," he says. "That effectively means that around one-third of the bonds are turning over each year, so money can be reinvested at higher yields if rates go up." He drills down to see what each fund is holding, and what its intentions are. Templeton Global Bond Fund, for example, tends to have a substantial position in Asia-Pacific bonds, less in the U.S. and Western Europe. "Osterweis Strategic Income Fund, another one of our holdings, has been buying short-term junk bonds that it expects to be redeemed," Martin says.

He also has a sizable position in gold. Martin regards it as an alternative to fixed income, because negative real yields that make some bonds unattractive signal an environment that's bullish for bullion.

In this environment, diversification and flexibility might be the best ways to approach fixed income. Plus, it might not hurt to hold some alternatives that stand to prosper if rising debt levels eventually take the bounce out of the bond market.